How To Be A Dividend King

Getting a big dividend check has to be one of the best parts about investing.  It’s certainly one of my favorites!  Nothing makes me feel more like a King than when the dividend checks come rolling in.

While I haven’t done a specific post on dividends yet, today’s the day!  People are usually amazed at the size of our dividend income when I report it every month.  

Last year our dividend income exceeded $100,000.  That was a pretty great year.  This year, our dividend income will be closer to $50k, which is still pretty significant.

Most financial independence bloggers don’t have this kind of dividend income, they mainly rely on capital appreciation — so I stand-out with my large ….. dividend income.  

(Did you think I was going to say tentacles?)

So why exactly is my dividend income so big?  Did I sacrifice quality in exchange for that income (with high yields, junk stocks, junk bonds, etc)?

The Tako Difference

One of the main differences between myself and other bloggers is my portfolio composition.  About 75% of our wealth is in two taxable portfolios, and the remaining 25% is in tax deferred accounts.  It wasn’t planned this way, but that’s just how life worked out.

Life hasn’t always been easy.  In my job history I didn’t always have access to a 401k plan.  

(Even when I did, that didn’t stop a company from raiding my 401k after I got laid off.  True story!  I lost around $25k in retirement funds after a layoff because a crappy 401k plan required 5 years of vesting before I owned a given year’s matching cash.  Aaarrrgh!)

The size of my tax deferred accounts ended up suffering because of this.  Life gave me lemons.  I made lemonade instead.

 We just kept saving as much as we could, and much of it ended up our taxable accounts.

Because the savings were in a taxable account, I had investing options other than mutual funds.  Stocks, bonds, preferred shares, REITS — all of these potential investments generate cash.  

Mutual funds typically are not big dividend payers — their dividends are frequently used for paying fund fees.  That’s right, those 1% fees when you invest in a mutual fund, your dividends end up paying those fees.

Index funds tend to be easier on the fees, but they usually hold so many stocks that the dividend yield ends up getting watered down by companies that don’t pay dividends (or only very small dividends).

I skipped these little problems, and focused on building a Dividend Growth portfolio instead.

Dividend Growth Investing (DGI)

Dividend Growth Investing is something of a holy grail for investors, especially those seeking financial independence.

The idea of receiving regular dividend payments from your investments is extremely appealing for someone who desires to live off passive income alone.  Even better, those dividend payments can grow faster than inflation, as the company continues to invest and improve the business.  This can lead to real wealth building if an investor holds on long enough.

Sounds pretty appealing doesn’t it?

There are a couple schools of thought around dividend growth investing:  Those who seek out high yield investments (which grow slowly) or low yielding investments that grow faster.

Why wouldn’t we pick high yield, high growth investments?

Great idea!  In an ideal world we could have both attributes.  But in reality both of those attributes are hard to find together.

Dividend Growth

Most businesses need cash to grow.  Machinery, stores, inventory, and so on.  They all take cash to grow.  In most types of business, the company with the most spare capital to invest should be able to grow the fastest.

But therein lies the problem — dividends compete for that same cash.  The business managers (CEO and board of directors) usually decide how much cash to pay out as dividends, and how much should be retained for growth projects.  They determine the payout ratio.

Those managers could choose to retain most of the cash for reinvesting in the business (or maybe just buy themselves that new corporate jet).  If that’s the case, a smaller chunk of cash is available for dividends.  This usually results in a lower payout ratio, but higher growth prospects.

The company could also choose to distribute most of the operating cash flow to shareholders in the form a large dividend.  Some kinds of companies (like REITs) even require it — but it also means very little cash is retained to grow the business.  

Can a high yielding company grow earnings enough to keep up with inflation?  Can they grow fast enough to build real wealth?

All good questions to answer before considering a higher yielding investment.

Which is Better?

Ultimately, the answer to this question is going to be pretty personalized.  Some people are going to fall into one camp (high growth), and others into the other camp (high yield).

Some investors are going to need high current income.  Maybe they didn’t save enough, but they still need income.  If that’s the case, higher-yielding investment often look attractive.

Other investors will limit income to minimize taxes.  Maybe they saved too much, and now generate too much income.  This kind of investor specifically picks stocks or mutual funds with lower yields (on purpose) to stay out of the higher tax brackets.  That’s a pretty “good problem” to have.

Whatever the case, high yield isn’t always the best course of action — Depending upon the starting yield and the rate of dividend growth, one would eventually expect the fastest grower to outgrow the ‘high-yield’ cousins.

But how long might that take?

Let consider a couple of different options:

• Company A – The 2.5% yielding company.  She doesn’t pay out much, but she’s a fast grower.  Dividend growth is expected to grow annually at 10% a year.
• Company B is something of a middle roader.  Sporting a 3.5% dividend yield, Company B still retains a big chunk of earnings for reinvestment (maybe 60% of earnings are retained).  This same company is expected to grow the dividend at a 7% rate.
• Company C is our high yield option.  With a dividend yield of 4.5%, this company spits off significant cash flows as dividends.  Because Company C retains so little cash for reinvestment, they also are the slowest growing of the three companies.  A 5% growth rate is expected over the coming years.

Ok, those are our three hypothetical options.  Which option going to have the best dividend rate over time?  It’s easiest to consider the answer in the form of  graph:

As you can see, Company C, (our high yielder) did really well in the early years.  Only after year 12 does the dividend growth of Company A and B exceed that of Company C.  

Yes, 12 years!  That’s a long time to wait!!  .

When you think about that, it’s pretty incredible…At normal dividend growth rates, it would take decades of holding a “faster grower” before the income exceed that of the high yielder.  

This leads me to concluded that: Dividend Growth Investing is only for the extremely patient.

Growth can be a little overrated, especially if you don’t have decades to live.  Growth is a younger person’s game.

The Dangers of High Yield

Unfortunately, high yield investments have additional risks.  The earnings payout ratio of a ‘high yield’ investment is typically higher (sometimes 50% or higher).  This means a high yield investments are more likely to need a dividend-cut when the next recession finally rolls around.  High yielding companies are most susceptible to potential financial difficulties during recessions.

When the “shit hits the fan”, dividend cuts are often the solution.

Dividend cuts can be a big problem…especially if you need that cash to buy groceries, or pay the mortgage.  Anyone that depends on dividend income alone for living expenses will want to avoid these kinds of high yield/higher risk investments.

Finding The Middle Ground

For the Tako family, we seek out a “middle ground” between high and low yield options.  I look for investments with decent growth, a sub 50% payout ratio, and a dividend yield that roughly matches my withdrawal rate (we like a 3% withdrawal rate).

Why do I try to match my dividend yields with my withdrawal rate?  So I don’t need to sell stock to pay expenses, and I won’t generate too much income!  But there’s also a secondary advantage — lower yields and faster dividend growth rates.  

Eventually, all that money I don’t need today will grow into something much larger…I just have to wait a few decades.  Dividend growth investing definitely isn’t for the impatient.  

Thankfully, we don’t need a lot of cash to live a good life.  Our stated goal is to live off our dividends in 2016 (roughly 48k in dividends).  That’s a 3% withdrawal rate from our taxable portfolio alone.  We’re just letting our tax deferred accounts (401k’s and IRA’s) grow right now.

We should be in good shape for significant portfolio growth in the future.

Low Growth Environments

Currently much of the developed world is in what I call a “low growth environment”.  Earnings growth has been low to nonexistent for the last 5 quarters.  This doesn’t bode well for dividends either.  Some people say a recession is coming.

They could be right.

Dividends should really only grow when earnings are growing.  If earnings aren’t growing, and dividends are, that means the payout ratio is rising.  This can sap future growth and make a dividend investment riskier over time.  A perfect real-life example to illustrate this would be Telus, one of the companies in my portfolio.  

Telus is a big cell phone and internet provider in Canada.  One of the big three in Canada (oligopoly economics apply in this case).  Back when I originally invested in late 2011, the payout ratio was roughly 60% of earnings…higher than I normally look for.  But the dividend was growing fast.  Combine that with a growing, low risk business (cell phones and internet) — I figured it might work out great.  Boy was I wrong.

Fast forward 5 years and now payout ratios are closer to 70%.  Debt levels are significantly higher, and earnings growth has been minimal.  Check out the last few years of results:

What the hell happened?

Several things combined to ruin this potentially great investment.  Exchange rates between the Canadian dollar and the U.S. dollar ended up destroying most of my dividend growth, and now the payout ratio is in the 70%+ range.  Debt levels are higher too.  I consider this a failure.  It’s pretty safe to say that I’m thinking about selling this investment.

From my point of view, the dividend didn’t grow (even though it did in Canadian dollars), and now the company is in a worse financial state.  

The stock appreciated over 40% (in USD) since my purchase, and I received 5% in dividend income per year.  That’s a combined return of 65% over 5 years.  A mere 13% annually.  What a disaster!  

I’m going to hold my head down in shame.  Just give me a moment….

….

See folks, I share my failures too.  Not just the wins.  Not every investment ends up being a gigantic multi-bagger.  Sometimes you just have to accept 13% returns…or less.

I don’t really have any great secrets to solving the problems of this low growth environment.  I want to keep dividends growing, but finding earnings growth in this environment is hard.  

I’m looking for either large diversified companies that are growing internationally (because earnings are not growing at home folks!), OR a smaller company that’s growing earnings in a very profitable niche.

Returns on Capital need to be excellent in either case.

Either way, I hold one rule sacred when dividend growth investing:  The dividends must grow without deteriorating the financial strength of the company.

[Image Credit: UnprecedentedMediocrity]